It's hard to quantify the impact of politics-driven volatility, but we're not changing our strategy yet

Individual investors often hear the phrase “priced into the market.” Analysts or advisors casually mention that “X” or “Y” factor has already been “priced into the market,” but what do they mean?

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On the surface, they are saying that the value of some fundamental factor has already been included in the price of a stock index like the S&P 500.

For example, let’s say that early indicators were all pointing to a really good retail sales number for the fourth quarter. No one is going to wait until the actual results are released to buy the best retail stocks. They may even pay a little extra.

The frustrating part of this phenomenon is that because the factor being “priced in” will happen in the future, no one knows for sure what its real value will be. Instead, we have to make guesses and estimates.

The Future of the Trade Deal

Sometimes, investors get too excited about a future event. They price in too much extra value before a big announcement. This is a common problem during earnings season. It’s one of the reasons stocks are much more likely to move more than 10% to the downside after companies release earnings than they are to move more than 10% to the upside.

The ambiguity around accurately pricing in a future event means we have to consider the risks of something being overpriced — or even worse, the possibility of an event or announcement not happening at all.

This is the issue that tripped up the market this week. Investors (including us) had been expecting more good news about the U.S.-China trade war and the release of a short-term deal. Therefore, we can assume that much of the value of that deal was already priced into the market.

However, on Monday and Tuesday, President Donald Trump threw cold water on investors’ expectations. He suggested he would be willing to wait until after the 2020 election for a deal with China. Plus, he announced the potential for reinstated tariffs on U.S. trading partners Argentina and Brazil.

This morning there were a few more “official rumors” that indicated that talks are still on track, but the damage has already been done.

Markets React

As you can see in the following chart, the Dow Jones Industrial Average pulled back to short-term support. The Russell 2000 performed similarly, while the S&P 500 did a little better as investors bought large-cap stocks off the lows on Tuesday.

Source: TradingView

Risk indicators like the CBOE Volatility Index (VIX), long-term Treasury bond yields and gold were also signaling stress following the trade developments.

The issue isn’t that the trade war is bad for market returns — we already knew that. The problem is that investors have already included some of the value of a resolution to the trade war in current prices. If the president pops the bubble of hope, sellers may hit the market hard.

No Need to Adjust Strategy Yet

Our goal in this week’s update is to explain why volatility spiked and why it is difficult to put a precise value on the potential damage. Now that we have discussed the recent volatility, we want to explain why we don’t think it is time to change the strategy just yet.

We have been saying this for a while, but we still believe that, if for no other reason than political expediency, a short-term resolution to the U.S.-China trade war is more likely than not.

However, there are a few places we recommend watching for some early warnings signs that traders may be heading for the exits.

China’s Indexes

Source: TradingView

China’s stock indexes are prone to selling frenzies and are a good leading indicator that the most skittish investors are starting to sell.

In the following chart, you can see that the Hang Seng (a Hong Kong stock index primarily made up of companies in the People’s Republic of China) is flirting with a “head-and-shoulders” bearish reversal pattern. If it breaks, we would expect prices to drop in North America as well.

High-Yield Bonds

Source: TradingView

High-yield bond funds are a great indicator for emerging selling in the market. High-risk bond investors tend to lead the market to the downside.

As you can see in the following chart, the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG) is nearing a short-term support level and has been forming a bearish divergence on the Moving Average Convergence Divergence (MACD) indicator since September’s highs.

Clearly, there is some weakness in this asset class that we should watch, but we don’t need to get overly concerned until HYG actually breaks support.

The Bottom Line on the Trade Deal

This week’s volatility is frustrating because it is hard to quantify. It’s being imposed on the market by an external factor — politics. This will put traders more on edge if we see more bad fundamental news.

For example, the Bureau of Labor Statistics will release the employment numbers for November on Friday. If the number of new jobs is lower than expected or wage growth is too slow, investors may use that as a trigger to sell.